Weekly Forex Currency Review 21-12-2007

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Overall strategy: There will be further concerns over the US economy in the short-term with the housing sector set for a prolonged downturn. There will also be increasing unease over global growth trends and the balance of these fears will be important in determining overall currency-market trends. Overall, the dollar will find it difficult to extend gains much further in the short-term while there is likely to be further caution over carry trades.                   

Key events for the forthcoming week

Dollar:

Position adjustment will remain an important short-term market influence with some further reduction in short dollar positions realistic, although erratic conditions will remain an important near-term threat. There will be persistent fears that the US economy will slide towards recession and the Fed will still find it difficult to stem speculation over further interest rate cuts which will prevent any sustained improvement in confidence towards the US currency with strong gains unlikely. The dollar should, however, secure some support from fears that global growth conditions will deteriorate while inflation fears will stem the more aggressive Fed rate expectations.    
      
The US dollar has retained a stronger tone over the week and pushed to highs near 1.43 against the Euro before a correction with the trade-weighted index also strengthening for the third consecutive week. There was significant position adjustment over the week as short dollar positions were reduced.

The US housing data remained weak with housing starts falling to an annual rate of 1.19mn from 1.23mn previously while permits were weak and there was particular concern over a further decline in single-family housing starts. Housing foreclosures also continued to rise strongly over the year.

The New York Empire index fell sharply in December to 10.3 from 27.4 the previous month. The Philadelphia Fed survey also weakened sharply to -5.7 for December from 8.2 previously which was the weakest figure since April 2003. Elsewhere, jobless claims rose to 346,000 in the latest week from 334,000 previously.

The current account deficit narrowed to US$179bn in the third quarter from US$189bn the previous quarter. This was equivalent to 5.1% of GDP with the deficit cut by a rising surplus on investment income.

The latest capital account data recorded net long-term inflows of US$114bn from a revised US$15.4bn the previous month as the immediate sub-prime panic subsided.

There was a series of credit rating downgrades over the week with the downgrading of the outlook for bond insurers MBIA and Ambac Financial important in increasing underlying credit fears while Bear Sterns reported a first-ever quarterly loss.

The Federal Reserve auction to add additional liquidity did not have a major impact on the US currency, although there was some relief for Wall Street.

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There is likely to be a further erosion of Euro-zone economic confidence in the short-term, especially with consumer spending liable to falter. The ECB will continue to face a tough task in balancing the needs to support growth conditions at the same time as controlling inflation. The bank's aggressive liquidity operations will also raise some fears over rapid money supply growth which will unsettle the currency. The Euro should still be able to avoid heavy selling pressure even if the current correction extends slightly further.     

The Euro was generally weaker over the week as there was a reduction in speculative positions with markets increasingly also less confident over Euro-zone fundamentals.

The German IFO index fell to 103.0 in December from 104.2 the previous month which reinforced expectations of a significant slowdown in the German economy, especially with the IFO warning that conditions had deteriorated. The Euro-zone services PMI index recorded a further slowdown for November with the manufacturing index little changed over the month.

ECB officials expressed concern over the Euro-zone growth outlook with Liebscher, for example, emphasising the downside risks, but there were further tough comments on inflation from the central bank.

The ECB moved to add in a huge amount of liquidity to support markets over the year-end period. Following the auction, there was speculation that funds were being switched out of Euros into other major currencies.

Yen:  

There will be further concerns over faltering growth within Japan, especially if wider export growth starts to deteriorate. The Bank of Japan will find it very difficult to justify a near-term increase in interest rates which will maintain the lack of yield support. International carry trades will still have a very important impact and there is still likely to be a further net reduction in risk appetite as credit difficulties intensify. In this environment, the yen is unlikely to weaken significantly and should still have a firmer net trend. 
                    
The yen was, in general, able to rest heavy selling pressure against the dollar, trading close to the 113.0 level for much of the week. The yen also secured an advance against the Euro for the week as a whole despite losing ground on Friday.

The Bank of Japan left interest rates at 0.50% following the latest council meeting. The vote this month was unanimous with Mizuno not calling for a rate increase after several months of voting for an increase.

The central bank lowered its growth forecast for the current fiscal year and was cautious over short-term economic prospects.

The latest weekly capital account data recorded a substantial net surplus on a flow of funds into money-market instruments. There was still evidence of retail selling interest during the week which stifled yen gains.

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Sentiment towards the UK economy is liable to deteriorate further in the short-term as growth continues to slow with the risk of a rapid slowdown. As the credit tightening takes effect, there will be strong pressure for further Bank of England interest rate cuts which will tend to undermine Sterling. The wider current account and budget deficits will also fuel wider concerns over the UK fundamentals. There will be intermittent corrections, but the net trend still looks to be for further Sterling depreciation.   
 
Sterling fell sharply for the week as a whole with four-month lows near 1.98 against the dollar. The UK currency also dropped back to November lows against the Euro at close to 0.7240 with the trade-weighted index at a 20-month low.

The consumer inflation data recorded that headline inflation was unchanged at 2.1% for November while the core rate fell further to 1.4% from 1.5%.

The third-quarter current account deficit rose strongly to a record GBP20bn from GBP13.7bn the previous quarter which was equivalent to 5.7% of GDP.

Government borrowing for November was also running at a record high which unsettled market confidence in the outlook, especially as slower revenue growth with reinforce fears over a sharp slowdown in growth. The latest CBI retail survey was the weakest of 2007 while retailers were more pessimistic over the short-term outlook. Retail sales rose 0.4% in November with annual growth static at 4.4%.

The Bank of England minutes from the December meeting recorded a 9-0 vote for a cut in interest rates as the Bank of England was significantly more concerned over the credit crunch and implications for the economy. These fears more than offset unease over potential inflationary pressure.

Swiss franc:

The Swiss economy should continue to perform well, especially in relation to the Euro-zone, even if the rate of growth slows significantly. Headline inflation is liable to increase further in the short-term which will increase pressure for a first-quarter National Bank interest rate increase. The franc will remain vulnerable to periodic selling on yield grounds, but the credit tightening is still liable to put some upward pressure on the Swiss currency in the first quarter.            
 
The Swiss franc weakened further against the dollar over the week with lows close to 1.16 which was the strongest US currency level since early November. The franc was unable to strengthen through 1.65 against the Euro.

The Swiss currency gained some support from a shift away from carry trades over the week as global credit fears persisted as further losses were announced.

Swiss retail sales and industrial production data recorded a slowdown in the latest data, although the data was still strong in historic terms.

National Bank member Jordan stated that the bank would take action to increase interest rates if franc weakness threatened to put upward pressure on inflation

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The Australian dollar weakened sharply over the first half of the week, but was able to stabilise above 0.8550 against the US currency with some advance against the Euro. The Australian dollar also pushed higher to 0.8670 on Friday.

The Reserve Bank of Australia took a tough stance on policy in the December policy minutes. The bank stated that policy would have been tightened if credit conditions had not deteriorated. Markets were less convinced that rates would be increased with the chances of a February rate increase being put at below 50%

The Australian dollar was hampered by an unwinding of carry trades and a drop in industrial commodity prices as global growth fears increased.

Liquidity issues will continue to be important surrounding the year-end period. Growth doubts, allied with reservations over carry trades, will continue to restrict the potential for Australian currency gains.

Canadian dollar:

The Canadian dollar found support close to 1.02 against the US dollar and strengthened to move back through parity for the first time in three weeks even though the US currency was generally strong against major currencies.

Headline consumer prices rose 0.3% in November, but core prices were unchanged for the month with the annual increase dropping to 1.6% from 1.8%, the lowest rate of increase for 18 months. There was market caution over shifting interest rate expectations ahead of Friday's retail sales and GDP data.

The Canadian currency did not weaken significantly on news of sharply negative portfolio capital flows for October. The currency was hampered to some extent by a drop in commodity prices while oil-price moves were erratic.

The Canadian dollar will struggle to extend gains much beyond parity against the US currency in the short-term, especially if global credit fears intensify.

Indian rupee:

The rupee weakened slightly against the dollar, primarily due to general gains for the US currency, although movements were still relatively subdued.

The rupee was close to 39.50 against the dollar on Thursday with trading conditions quiet ahead of an Indian market holiday on Friday.

There were reports that overseas investors sold around US$800mn of Indian stocks over the first two days of the week, but conditions stabilised thereafter.

The rupee will still find it difficult to make significant short-term gains with the global credit and growth fears limiting the scope for renewed capital inflows.

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The Hong Kong dollar weakened to beyond the 7.80 level against the US currency during the week before regaining some ground and settling close to 7.80.

There was some renewed widening of US dollar spreads over the Hong Kong dollar which encouraged arbitrage activity and undermined the local currency.

The consumer inflation rate increased to 3.4% in the year to November and the HKMA will need to be vigilant over inflation which should support domestic yields.

Overall, the Hong Kong dollar should be able to find further near-term support just weaker than 7.80 against the US dollar, although gains will be limited.

Chinese yuan:

The Chinese yuan was little changed for much of the week at around 7.37 against the dollar, although it gained ground significantly against the Euro. The Chinese currency also advanced to fresh post-float highs beyond 7.36 on Friday.

The Chinese central bank increased interest rates for the sixth time this year in an attempt to control inflation. The main lending rate was increased by 0.16% to 7.47% while there were bigger increases for deposit rates.

The central bank appeared comfortable with a firmer currency and guiding the reference rate stronger following the latest interest rate increase.

There was evidence of some seasonal pressures on the yuan with capital repatriation from international companies with holdings in China and this boosted short-term US currency demand which limited yuan gains.

The tighter monetary policy will maintain pressure for further underlying yuan gains with the potential for a faster pace of appreciation to be tolerated.